Mechanics Of Options Contracts

Question 4. [Options Trading Strategies – StockTrak Simulation]

This homework question provides a useful experiential learning and preparation for your Individual Assignment – Part II Derivatives Trading Simulation.

Instructions: For Question 4 of this homework, provide and discuss two examples of Option trades that you have implemented in the StockTrak simulation for your Individual Assignment – Part II. Provide discussions of your own insights, analysis, timing and outcomes of your option trading strategies.

Suggestions: Examples of derivative trading strategies include (but are not limited to) the following: long call, long put, short call, short put, bull spread, bear spread, butterfly spread, condor, straddle, strangle, etc. Also, you may trade option contracts on different underlying assets (such as stock, ETF, etc.) in the StockTrak simulation. The followings provide further instructions and suggestions on Derivatives Trading Simulation.

Further Suggestions and Instructions: Derivatives Trading Simulation Review the following important information and instructions regarding option exercising in derivatives trading simulation. Note that there are different (mutually exclusive) possibilities to make profits: Profits from option trading OR Profits from option exercising (BUT NOT BOTH). You may choose one of the following possibilities to make profits from options: Choice (1) Profits from trading options “before expiration”: In the simulation, you can create profits from trading (buying/selling) options “before expiration”. Before expiration of the option contracts, you may make profits from selling existing option contracts you already had. OR

Question 4 continued next page

Question 1. – Part (A) True or False? “Short Put Option provides the right (but not the obligation) to buy the underlying asset for the strike price at maturity.” Explain your answer with example(s). (Hint: review Class #6 presentation)

Question 1. – Part (B) True or False? “An American option can never be worth less than the corresponding European option.” Explain your answer with example(s). (Hint: review Class #6 presentation)


Choice (2) Profits from options “at expiration”: Alternatively, you can hold your option contracts “at/until expiration”. If you hold your option contracts at expiration, the StockTrak simulation system will settle the contracts in cash.1 OR Choice (3) Profits from early exercising options “before expiration”: You can create profits from early exercise of options. In this case, you may consider the following steps and information:

See and choose “Q: HOW DO I EXERCISE OPTIONS?” To help make decision on early exercise of options, you can compute any profits of early exercising options by yourself. To compute Profits from early exercising options, you can use the Excel model “Model of Exercising Options” provided in Blackboard (“Course Materials”) to calculate any profits from option exercise. For example, you can use the Excel model at Blackboard to compute the profits of exercising options as follows:

The calculations in the above spreadsheet do not account for trading costs and commission fees.2 In the StockTrak simulation, we use the setting of $10 per trade for options and futures (which is different form the trading costs in actual markets).3 The followings provide useful information on Options: Tutorials and Basics of Options: Option Trading Page: Useful (Updated) Information, Quotes, Trading Volume, and Open Interest from

the CBOE: Trading Options: content&content=Trading-Options&title=TradeOptions

1 If you have an in-the-money option at expiration, your profitable option contracts will be automatically closed out at expiration. This is similar to a procedure in practice known as “exercise by exception”. 2 See Jarrow and Chatterjea (2013), Chapter 5, p. 124: “Commission rates vary. A discount broker typically charges a fixed rate, which may be as small as $5 to $20 per trade, and a variable rate, which typically ranges from 50 cents to $2 for each option on one hundred shares.” 3 See the following information and example of option trading costs in StockTrak: “The estimated cost is the order quantity x last traded price x 100 + any commissions. Option contracts are for 100 shares of a given stock.”

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